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Understanding AS-2 with Illustrations

The accounting treatment for inventories is prescribed in AS  2  (Revised)  ‘Valuation of Inventories’, which provides guidance for determining the value at which inventories, are carried in the financial statements  until  related  revenues are recognised. It also provides guidance on the cost formulas that are used to assign costs to inventories and any write-down thereof to net realisable value.

Inventories

AS 2 (Revised) defines inventories as assets held

  • for sale in the ordinary course of business, or
  • in the process of production for such sale, or
  • for consumption in the production of goods or services for sale, including maintenance supplies and consumables other than machinery spares, servicing equipment and standby equipment meeting the definition of Property, plant and equipment.

Inventories encompass goods purchased and held for resale, for example merchandise (goods) purchased by a  retailer and held for  resale, or land and  other property held for resale. Inventories also include finished goods produced,  or work in progress being produced, by the enterprise and include materials, maintenance supplies, consumables and loose tools awaiting use in  the  production process. Inventories do not include spare parts, servicing equipment and standby equipment which meet the definition of property, plant and equipment as per AS 10 (Revised), Property, Plant and Equipment. Such items are accounted for in accordance with Accounting Standard (AS) (Revised) 10, Property, Plant and Equipment.

Following are excluded from the scope of AS 2 (Revised).

  1. Work in progress arising under construction contracts, i.e. cost of part construction, including directly related service contracts, being covered under AS 7, Accounting for Construction Contracts; Inventory held for use in construction, g. cement lying at the site should however be covered by AS  2 (Revised).
  2. Work in progress arising in the ordinary course of business of service providers e. cost of providing a part of service. For example, for a shipping company, fuel and stores not consumed at the end of accounting period is inventory but not costs for voyage-in-progress. Work-in-progress may arise for different other services e.g. software development, consultancy, medical services, merchant banking and so on.
  3. Shares, debentures and other financial instruments held as stock-in-trade. It should be noted that these are excluded from the scope of AS 13 (Revised) as well. The current Indian practice is however to  value them at lower of cost and fair value.
  4. Producers’ inventories of livestock, agricultural and forest products, and mineral oils, ores and gases to the extent that they are measured at net realisable value in accordance with well established practices in those industries, g. where sale is assured under a forward contract or a government guarantee or where a homogenous market exists and there is negligible risk of failure to sell.

The types of inventories are related to the nature of business. The inventories of a trading concern consist primarily of products purchased for resale in their existing form. It may also have an inventory of supplies such as wrapping paper, cartons, and stationery. The inventories of manufacturing concern consist of several types  of inventories: raw material (which will become part of the goods  to  be  produced), parts and factory supplies, work-in-process (partially completed products in the factory) and, of course, finished products.

At the year end every business entity needs to ascertain the closing balance of Inventory which comprise of Inventory of raw material, work-in-progress, finished goods and miscellaneous items. The cost of closing inventory, e.g. cost of closing stock of raw materials, closing work-in-progress and closing finished stock, is a  part of costs incurred in the current accounting period that is carried over to next accounting period. Likewise, the cost of opening inventory is a part of costs incurred in the previous accounting period that is brought forward to current accounting period.

Since inventories are assets, and assets are resources expected to generate future economic benefits to the enterprise, the costs to be included in  inventory costs,  are costs that are expected to generate future economic benefits  to  the  enterprise. Such costs must be costs of acquisition and costs incurred in bringing the assets to their present (i) location of  the inventory, e.g. freight incurred to  carry the materials to factory and (ii) conditions of the inventory, e.g.  costs  incurred to convert the materials into finished stock. The costs incurred  to  maintain the inventory, e.g. storage costs, do not generate any extra economic benefits for the enterprise and therefore should not be  included  in  inventory costs unless those costs are necessary in production process prior to a further production stage.

The valuation of inventory is crucial because of its direct impact in measuring profit/loss for an accounting period. Higher the value of closing inventory lower is the cost of goods sold and hence higher is the profit. The principle of prudence demands that no profit should be anticipated while all foreseeable losses should  be recognised. Thus, if net realisable value of inventory is less than inventory cost, inventory is valued at net realisable value to reduce the reported profit in anticipation of loss. On the other hand, if net realisable value of inventory is more than inventory cost, the anticipated profit is ignored and the inventory  is  valued  at cost. In short, inventory is valued at lower of cost and net realisable value. The standard specifies (i) what the cost of inventory should consist of and (ii) how the net realisable value is determined.

Failure of an item of inventory to recover its costs is unusual.  If  net  realisable value of an item of inventory is less than its cost, the fall in profit in consequence   of writing down of inventory to net realisable is an unusual loss and should be shown as a separate line item in the Profit & Loss statement to help the users of financial statements to make a more informed analysis of the enterprise performance.

By their very nature, abnormal gains or losses are not expected to recur regularly. For a meaningful analysis of an enterprise’s performance, the users of financial statements need to know the amount of such gains/losses included in current profit/loss. For this reason, instead of taking abnormal gains and losses in  inventory costs, these are shown in the Profit and Loss statement in such way that their impact on current profit/loss can be perceived.

Part I of Schedule III to the Companies Act, 2013 prescribes that valuation method should be disclosed for inventory held by companies.

Measurement of Inventories

Inventories should be valued at lower of cost and net realisable value. Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. The valuation of inventory at lower of cost and net realisable value is based on the view that no asset should be carried at a value which is in excess of the value realisable by its sale or use.

Measurement of Inventories

Example 1

Cost of a partly finished unit at the end of 2016-17 is 150. The  unit  can  be  finished next year by a further expenditure of 100. The finished unit can be sold at   250, subject to  payment of 4% brokerage on selling price. The value of  inventory  is determined below:

Particulars
Net selling price 250
Less: Estimated cost of completion (100)
150
Less: Brokerage (4% of 250) (10)
Net Realisable Value 140
Cost of inventory 150
Value of inventory (Lower of cost and net realisable value)

140

Costs of inventory

Costs of inventories comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.

Costs of purchase

The costs of purchase consist of the purchase price including duties and taxes (other than those subsequently recoverable by the enterprise from the taxing authorities, and other expenditure directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks and other similar items are deducted in determining the costs of purchase.

Costs of Conversion

The costs of conversion include costs directly related to production, e.g. direct labour. They also include overheads, both fixed and variable that are incurred in converting raw material to finished goods.

The fixed production overheads should be absorbed systematically to units of production over normal capacity. Normal capacity is  the  production  the enterprise expects to achieve on an average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity  resulting from planned maintenance. The actual level of production may be used if it approximates the normal capacity. The amount of fixed production overheads allocated to each unit of production should not be increased as a consequence of low production or idle plant. Unallocated overheads (i.e. under recovery) are recognised as an expense in the period in which they are incurred. In periods of abnormally high production, the amount of fixed production overheads allocated to each unit of production is decreased so that inventories are not  measured above cost. Variable production overheads are assigned to each  unit  of production on the basis of the actual use of the production facilities.

Example 2

ABC Ltd. has a plant with the capacity to produce 1 lac unit of a product per annum and the expected fixed overhead is 18 lacs. Fixed overhead on the basis of normal capacity is 18 (18 lacs/1 lac).

Case 1: Actual production is 1 lac units. Fixed overhead on the basis of normal capacity and actual overhead will lead to same figure of 18 lacs. Therefore it is advisable to include this on normal capacity.

Case 2: Actual production is 90,000 units. Fixed overhead is not going to  change  with the change in output and will remain constant at 18 lacs,  therefore, overheads on actual basis is 20 per unit (18 lacs/ 90 thousands). Hence by valuing inventory at 20 each for fixed overhead purpose, it will be overvalued  and  the losses of 1.8 lacs will also be included in closing inventory leading to a  higher gross profit then actually earned. Therefore, it is advisable to include fixed overhead per unit on normal capacity to actual production (90,000 x 18) 16.2 lacs and rest 1.8 lacs should be transferred to Profit & Loss Account.

Case 3: Actual production is 1.2 lacs units. Fixed overhead is not going to change  with the change in output and will remain constant at 18 lacs,  therefore, overheads on actual basis is 15 (18 lacs/ 1.2 lacs). Hence by valuing inventory at 18 each for fixed overhead purpose, we will be adding the element of cost to  inventory which actually has not been incurred. At 18 per unit,  total  fixed  overhead comes to 21.6 lacs whereas, actual fixed overhead expense is only 18 lacs. Therefore, it is advisable to include fixed overhead on actual basis (1.2 lacs x 15) 18 lacs.

Joint or By-Products

In case of joint or by products, the costs incurred up to  the stage of split off  should be allocated on a rational and consistent basis. The basis of allocation may be sale value at split off point, for example, value of by  products, scraps and  wastes are usually not material. These are therefore valued at net realisable value. The cost of main product is then valued as joint cost minus net realisable value of by-products, scraps or wastes.

Other Costs

  1. These may be included in cost of inventory provided they are incurred to bring the inventory to their present location and Cost of design, for example, for a custom made unit may be taken as part of inventory cost.
  2. Interest and other borrowing costs are usually considered as not relating to bringing the inventories to their present location and condition. These costs are therefore not usually included in cost of inventory. Interests and other borrowing costs however are taken as part of inventory costs, where the inventory necessarily takes substantial period of time for getting ready for intended Example of such inventory is wine.
  3. The standard is silent on treatment of amortisation of intangibles for ascertaining inventory It nevertheless appears that amortisation of intangibles related to production, e.g. patents right of production or copyright for a publisher should be taken as part of inventory costs.
  4. Exchange differences are not taken in inventory cost.

Conversion Cost

*When actual production is almost equal or lower than normal capacity.

** When actual production is higher than normal capacity.

*** Allocation at reasonable and consistent basis.

Exclusions from the cost of inventories

In determining the cost of inventories, it is appropriate to  exclude certain costs  and recognise them as expenses in the period in which they are  incurred.  Examples of such costs are:

  1. Abnormal amounts of wasted materials, labour, or other production costs;
  2. Storage costs, unless the production process requires such storage;
  3. Administrative overheads that do not contribute to bringing the inventories to their present location and condition;
  4. Selling and distribution cost.

Cost Formula

Mostly inventories are purchased / made in different lots and unit cost of each lot frequently differs. In all such circumstances, determination of closing inventory cost requires identification of units in stock to have come from  a  particular lot. This specific identification is best wherever possible. In all other cases, the cost of inventory should be determined by the First-In First-Out (FIFO), or Weighted Average cost formula. The formula used should reflect the fairest possible approximation to the cost incurred in bringing the items of inventory to their present location and condition.

Other techniques of cost measurement

  1. Instead of actual, the standard costs may be taken as cost of inventory provided standards fairly approximate the actual. Such standards (for finished or partly finished units) should be  set in  the light of normal levels  of material consumption, labour efficiency and capacity The standards so set should be regularly reviewed and if  necessary,  be  revised to reflect current conditions.
  2. In retail business, where a large number of rapidly changing items are  traded, the actual costs of items may be difficult to The units dealt by a retailer however, are usually sold for similar gross margins and a retail method to determine cost in such retail trades makes use of the  fact.  By this method, cost of inventory is determined by reducing sale value of unsold stock by appropriate average percentage of gross margin.

Example 3

A trader purchased certain articles for 85,000. He sold some of articles for 1,05,000. The average percentage of gross margin is 25%  on  cost. Opening stock  of inventory at cost was 15,000.

Cost of closing inventory is shown below:

Particulars
Sale value of opening stock and purchase ( 85,000 + 15,000) x 1.25 1,25,000
Sales (1,05,000)
Sale value of unsold stock 20,000
Less: Gross Margin (₹ 20,000 / 1.25) x 0.25 (4,000)
Cost of inventory 16,000

Estimates of Net Realisable Value

Estimates of net realisable value are based on the most reliable evidence available at the time the estimates are made as to the amount the inventories are expected to realise. These estimates take into consideration fluctuations of price or cost directly relating to events occurring after the balance sheet date to  the  extent that such events confirm the conditions existing at the balance sheet date.

Comparison of Cost and Net Realisable Value

The comparison between cost and net realisable value should be made on item- by-item basis. In some cases nevertheless, it may be appropriate to  group similar or related items.

Example 4

The cost, net realisable value and inventory value of two items that a company has  in its inventory are given below:

 

Cost Net Realisable Value Inventory Value
Item 1 50,000 45,000 45,000
Item 2 20,000 24,000 20,000
Total 70,000 69,000 65,000

Estimates of NRV should be based on evidence available at the time of estimation.

Net realisable value is the estimated selling price in the ordinary course of  business less the estimated costs of completion and the  estimated  costs necessary to make the sale. AS 2 (Revised) also provides that estimates of net realisable value are to be based on the most reliable evidence available  at  the time the estimates are made as to the amount the inventories are expected to realise. These estimates take into consideration fluctuations of price or cost  directly relating to events occurring after the balance sheet date to  the  extent that such events confirm the conditions existing at the balance sheet date.

NRV of materials held for use or disposal

Materials and other supplies held for use in the production of inventories are not written down below cost if the selling price of finished product containing the material exceeds the cost of the finished product. The reason is, as long as these conditions hold the material realises more than its cost as shown below.

Review of net realisable value at each balance sheet date

An assessment is made of net realisable value as at each balance sheet date.

Disclosures

The financial statements should disclose:

  1. The accounting policies adopted in measuring inventories, including  the cost formula used; and
  2. The total carrying amount of inventories together with a classification appropriate to the enterprise.

Information about the carrying amounts held in different classifications of inventories and the extent of the changes in these assets is useful to financial statement users. Common classifications of inventories are

  1. raw materials and components,
  2. work in progress,
  3. finished goods,
  4. Stock-in-trade (in respect of goods acquired for trading),
  5. stores and spares,
  6. loose tools, and
  7. Others (specify nature).

Illustration 1

The company deals in three products, A, B and C, which are neither similar nor interchangeable. At the time of closing of its account for the year 2016-17, the Historical Cost and Net Realisable Value of the items of closing  stock  are  determined as follows:

Items Historical Cost ( in lakhs) Net Realisable Value ( in lakhs)
A 40 28
B 32 32
C 16 24

What will be the value of closing stock?

Solution

As per AS 2 (Revised) on ‘Valuation of Inventories’, inventories should be valued   at the lower of cost and  net realisable value. Inventories should be  written down  to net realisable value on an item-by-item basis in the given case.

Items Historical Cost ( in lakhs) Net Realisable Value ( in lakhs) Valuation of closing stock ( in lakhs)
A 40 28 28
B 32 32 32
C 16 24 16
88 84 76

Hence, closing stock will be valued at ₹ 76 lakhs.

Illustration 2

X Co. Limited purchased goods at the cost of 40  lakhs in  October,  2016.  Till March, 2017, 75% of the stocks were sold. The company wants to disclose closing stock at 10 lakhs. The expected sale value is 11 lakhs and a commission at 10%  on sale is payable to the agent. Advise, what is the correct closing stock to be disclosed as at 31.3.2017.

Solution

As per AS 2  (Revised) “Valuation of Inventories”, the inventories are to be valued  at lower of cost or net realisable value.

In this case, the cost of inventory is ₹ 10 lakhs. The net realisable value  is  11,00,000 ´ 90% = ₹ 9,90,000. So, the stock should be valued at ₹ 9,90,000.

Illustration 3

In a production process, normal waste is 5% of input. 5,000 MT of input were put in process resulting in wastage of 300 MT. Cost per MT of input is 1,000. The entire quantity of waste is on stock at the year end. State with reference to Accounting Standard, how will you value the inventories in this case?

Solution

As per AS 2 (Revised), abnormal amounts of wasted materials, labour and other production costs are excluded from cost of inventories and such costs are recognised as expenses in the period in which they are incurred.

In this case, normal waste is 250 MT and abnormal waste  is  50  MT. The cost of  250 MT will be included in determining the cost of inventories (finished goods) at the year end. The cost of abnormal waste (50 MT x 1,052.6315 = ₹ 52,632) will be charged to the profit and loss statement.

Cost per MT (Normal Quantity of 4,750 MT) = 50,00,000 / 4,750 = ₹ 1,052.6315

Total value of inventory = 4,700 MT x ₹ 1,052.6315 = ₹ 49,47,368.

Illustration 4

You are required to value the inventory per kg of finished goods consisting of:

 

per kg.
Material cost 200
Direct labour 40
Direct variable overhead 20

Fixed production charges for the year on normal working capacity of 2 lakh kgs is 20 lakhs. 4,000 kgs of finished goods are in stock at the year end.

Solution

In accordance with AS 2 (Revised), the cost of conversion include a systematic allocation of fixed and variable overheads that are incurred  in  converting materials into finished goods. The allocation of fixed overheads  for  the purpose  of their inclusion in the cost of conversion is based on normal capacity of the production facilities.

Cost per kg. of finished goods:

Material Cost 200
Direct Labour 40  

 

70

Direct Variable Production Overhead 20
Fixed Production Overhead (20,00,000/2,00,000)
10
270

Hence the value of 4,000 kgs. of finished goods = 4,000 kgs x ₹ 270 = ₹ 10,80,000

Illustration 5

On 31st March 2017, a business firm finds that cost of a partly finished unit on that date is 530. The unit can be finished in 2017-18 by an additional expenditure of ₹ 310.  The finished unit can be sold for 750 subject to payment of 4% brokerage on selling price. The firm seeks your advice regarding the amount at which the unfinished unit should be valued as at 31st March, 2017 for preparation of final accounts. Assume that the partly finished unit cannot be sold in semi finished form and its NRV is zero without processing it further.

Solution

Valuation of unfinished unit

Net selling price 750
Less: Estimated cost of completion (310)
440
Less: Brokerage (4% of 750) (30)
Net Realisable Value 410
Cost of inventory 530
Value of inventory (Lower of cost and net realisable value) 410

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